What Wall Street Can Do to Avoid Overregulation

Complaints and lawsuits cannot solve the problem of overregulation, only ideas can, but for an industry built on ideas for success, Wall Street seems surprisingly short of creativity.

Broadly speaking, Wall Street exists for three reasons: 1) to provide a reliable system for the interchange of money; 2) to provide financial advice and capital for businesses, and; 2) to generate wealth for investors; and in serving these needs, Wall Street performs a valuable function for society. But there is also another reason for its existence, and that is to enrich the banking community itself, and in the case of our biggest banks, much of that wealth comes from the creation, sale, and trading of complex financial instruments called derivatives.

The sheer size of the derivatives market, estimated at $630 trillion dollars, and its inherent volatility offer opportunities for huge profit-making, but unfortunately also contain the potential for causing chaos throughout the economy, as we saw in 2008. In that case, subprime mortgage-backed securities and insurance policies on those securities (credit default swaps) combined to form a financial Molotov cocktail, leading to bets being made on the same assets multiple times (thereby worsening the impact of defaults on the underlying mortgages), wiping out many billions of dollars in wealth, and ultimately bringing the entire economy down.

In the wake of that disaster, it is not unreasonable for the Commodity Futures Trading Commission (CFTC) to regulate the derivatives market closely, and to expect US firms to follow roughly the same rules internationally as they do stateside, since cross-border transactions can impact our markets in much the same way that domestic ones do.

But now three Wall Street trade groups have filed a lawsuit against the CFTC over some of these rules, and a bruising battle between Wall Street and the US government seems imminent. Their specific complaint – that the CFTC issued new rules without soliciting public input by simply tacking them onto existing ones, has validity, but in trying to battle overregulation in this manner, Wall Street is making a mistake – especially when there is a better way.

It is important for the banking community to recognize two things. First, after the financial crisis, with Dodd-Frank now a reality, and with new asset bubbles forming in our economy again (for example, in the car loans business), it is virtually impossible that the financial arena will escape stricter regulation. Second, the reason that the government has to regulate the markets is because Wall Street has been unable to police itself, with the LIBOR scandal, the London Whale losses at JPMorgan Chase, and other transgressions belying any lip service that the industry might give to the public.

Since Wall Street’s primary objection in its lawsuit is that the CFTC issued new rules without public input, it would be better served advancing its own ideas publicly on what those rules should be rather than simply opposing whatever the CFTC does. So far Wall Street has been scathingly critical of Dodd-Frank, the Volcker Rule, and now the CFTC’s rules governing international derivatives transactions, but has failed to advance any constructive ideas of its own on how to regulate the financial markets in a way that protects the economy from Wall Street irresponsibility but does not impose an unreasonable burden on the industry. It is true that banking lobbies have been working behind the scenes to reshape Dodd-Frank even as it rolls out, but those efforts are mostly directed at weakening the law and not at solving the bigger problem.

Government bureaucrats may not be the best qualified to determine the right regulatory framework for the banking industry, but so far they are the only ones who have tried, and so Wall Street has no one to blame but itself for the regulations that it is now facing. Smart bankers could very likely craft more pragmatic rules but only if they show up to do so.

What Wall Street needs to do now is to accept the new regulatory reality that it faces, come up with creative solutions to reassure the public about how it will conduct its business profitably without endangering our economy, and push for a national debate on those ideas. That will not stop the government from acting (and neither should that be the goal), but it will at least enable Wall Street to provide some meaningful input into the process, and to reach some middle ground that will be acceptable to the nation as well as the banking industry.

Bio:SANJAY SANGHOEE is a political and business commentator. He has worked at leading investment banks Lazard Freres and Dresdner, as well as at multi-billion dollar hedge fund Ramius. His opinion pieces have appeared in TIME, Bloomberg Businessweek, FORTUNE, and Christian Science Monitor, and he has appeared on CNBC’s ‘Closing Bell’, TheStreet.com, and HuffPost Live on business topics. He is also the author of two thriller novels. For more information, please visit http://www.sanghoee.com